Hedging – What is it and Why Should You Care?

There’s an old adage which suggests that “you need to speculate to accumulate”, and while this seems like quite a glib statement it’s also one that betrays the importance of investment and boosting your savings in a strained economic climate.

This explains the popularity of the financial markets in the current climate, with volatile and margin-based entities such as the foreign exchange seeing more than $5 trillion traded globally every single day.

However, it’s important to understand the importance of ‘hedging’ when investing your money, but what does this term mean and why should you care as a financial trader?

What is Hedging?

 Not only is hedging a concept that’s all-to-easy for investors to overlook, but it’s often misunderstood amongst new or inexperienced traders.

In simple terms, hedging refers to the act of protecting your capital during the course of investing it, and this holds particular importance when dealing in volatile and derivative entities such as forex trading.

The reason for this is simple; as investments of this type are speculative and don’t require you to assume ownership of an underlying financial instrument, and while this offers greater leverage, it also leaves you without a secure store of wealth.

Investments like this (and indeed of any description) are also vulnerable to several external factors that exist outside of your control, from the geopolitical climate and market sentiment to various macroeconomic aspects such as interest rates and inflation.

As we’ve seen from the Covid-19 outbreak, pandemics and natural disasters can also have a devastating impact on currency values and the success or failure of associated investments.

In the case of coronavirus, we’ve also seen how quantitative easing measures have seen countries slash the base interest rates and subsequently lower both the demand for and value of respective currencies.

An Example of Hedging

 As we can see, investments such as forex trades are inherently vulnerable in a number of different ways, and hedging enables you to build a protective barrier around your capital and minimise the value of potential losses.

On a fundamental level, buying car insurance can be viewed as a very basic form of hedging, as this protects your investment in the event of a crash or accident.

From the perspective of forex trading, investors will often create a hedge to fully protect an open order from an undesirable price move in a currency pairing, simply by holding both a short and long position simultaneously.

This is often referred to as the ‘perfect hedge’ as it eliminates virtually all risk from the trade and minimises your exposure in challenging market conditions.

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